Friday, March 13, 2009

Another reason for a co-ordinated global fiscal expansion

I had blogged earlier about Paul Krugman's arguement that fiscal policies have strong positive policy externalities, and therefore "if macro policy isn’t coordinated internationally we’ll tend to end up with too little fiscal stimulus, everywhere" and protectionism as nations try to capture all benefits locally.

An IMF research paper finds even more reasons for globally co-ordinated fiscal stimulus - they have higher multipliers than individual nations acting alone. It writes, "The (multiplier) effect on US GDP of investment expenditures is 3.9 when there is global fiscal expansion and only 2.4 when the United States acts alone. Similarly, the effect on Japanese GDP of targeted transfers is 1.5 when there is global fiscal expansion and only 1.0 when Japan acts alone. Differences in multipliers across regions relate to the size of leakages in the different areas, including leakages into saving and imports."

The reports also favors government investment over tax cuts, claiming that for "every dollar spent on government investment can increase GDP by about $3, while every dollar of targeted transfers can increase GDP by about $1". It also finds that "due to international spillovers of demand, simultaneous fiscal stimulus alone can raise each region’s multipliers by a factor of about 1.5, while coupled with monetary accommodation (by the Central Banks) can achieve even larger improvements".

It argues that given the likelihood of the recession being long drawn out, government investment may not be limited by the absence of immediate "shovel-ready" projects and the concern that the expenditures will only be put into place once the economy has begun to recover. It underscores the primacy of "fiscal policy to take on an increased share of the burden during the period in which the financial sector is recovering and is not yet able or willing to extend credit to households and businesses to the extent that it normally does".

Further, in order to unwind the debts run up during such fiscal expansions, it also suggests "appropriate and credible medium-term fiscal frameworks, such as increased emphasis on containing the ratio of public debt to GDP, and the introduction of fiscal rules of the sort used in Chile, which clearly articulate a long-run target for the ratio of the fiscal deficit to GDP and therefore implicitly for the ratio of public debt to GDP". Such targets provide an anchor for medium term inflationary and interest rate expectations.

The paper also suggests that during fiscal expansions, the monetary policy rate should be held constant at its pre-stimulus value for one or two years (as opposed to the forward-looking Taylor-type interest rate rule that during normal times adjusts nominal policy interest rates in response to one-year-ahead forecasts of inflation), thereafter returning to the conventional interest rate rule to anchor inflation in the long run.

In another NBER working paper, Frederic Mishkin argues in favour of decisive conventional and unconventional monetary policy actions which he claims are "more potent during financial crises because aggressive monetary policy easing can make adverse feedback loops less likely".